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Praise for Smart Power

— MARK CRISSON, Chief Executive Officer of the American Public Power Association “Probably the best holistic treatment of the critical issues facing the electricity industry that I have ever read.”

— JOHN CALDWELL, Director of Economics at the Edison Electric Institute “Few economists or engineers understand the electricity system as well as Peter Fox-Penner, and far fewer can explain it as lucidly. His vision of the opportunities, risks, uncertainties, and tipping points of this vast and crucial industry is powerful and provocative.”

— AMORY B. LOVINS, Chairman and Chief Scientist, Rocky Mountain Institute “If you’re serious about policies that place energy efficiency on a level playing field with new energy supplies, and energy policy generally, this book is essential reading.”

— ART ROSENFELD, former Commissioner of the California Energy Commission “Smart Power is the most advanced look at how climate policies will change our energy utilities, from power sources to operations to business models. It’s a must read for anyone serious about climate solutions.”

— JOE ROMM, Editor of ClimateProgress.org and Senior Fellow at the Center for American Progress DR. PETER FOX-PENNER is an internationally recognized expert on the electric power industry, energy economics, and policy. He is also principal and chairman emeritus of The Brattle Group. www.smartpowerbook.com Cover design: Roberto de Vicq Cover illustrations: Alternative Energy © Aaltazar courtesty of iStockphoto.com

Washington | Covelo | London www.islandpress.org All Island Press books are printed on recycled, acid-free paper.

smart power | anniversary edition

“A valuable and insightful analysis of where the U.S. electric power industry is headed and what it must do to successfully transition to a low-carbon environment. This book should be required reading for all industry regulators as they prepare to confront the challenges of this new paradigm.”

Fox-Penner

New Forewords by James E. Rogers, Dan Esty, Daniel Dobbeni, and Lyon Rive

“An absolutely terrific piece of work—remarkable scope and depth, while remaining accessible and pragmatic.”

—JOHN KWOKA

anniversary edition

C L I M AT E C H A N G E, T H E S M A R T G R I D, & THE FUTURE OF ELECTRIC UTILITIES

Peter Fox-Penner

Praise for

Smart Power

“This book is an absolute masterpiece! The overview of industry operations provided is extremely helpful for a novice like me. And the deep insights offered into pressing industry issues are invaluable for someone who is trying to identify useful research topics.”

—David Sappington, Director of the Robert F. Lanzillotti Public Policy Research Center

“Smart Power paints a sharp picture of the historic challenges facing the utility industry, its regulators, and the nation at large. Peter Fox-Penner’s urgent call for a bottom-up solution relying on local, state, and regional cooperation and creativity presages the work now ongoing across the country. Smart Power is an essential read for policymakers looking for workable solutions for the next decade and beyond.”

—Charles Gray, Executive Director of the National Association of Regulatory Commissioners

“Many commentators have argued that the global energy system will change more in the next decade than it has in the last century. To navigate this complex terrain, you couldn’t ask for a better guide than Peter Fox-Penner. Smart Power provides a fascinating account of how new technologies, policies, and business models may create a more secure, intelligent, and sustainable energy system.”

—Dan Vermeer, Executive Director of Duke University’s Center for Energy, Development, and the Global Environment (EDGE)

“Peter Fox-Penner leads us carefully through an electrical future of distributed generation, microgrids, energy efficiency, new service companies, and clean resources, ‘one interlocking whole, not mix-and-match elements.’ Economic efficiency, reliability, and innovation will require all the technological and institutional components of this new system to cohere, in part by means of a robust and highly integrated high-voltage transmission grid that today remains largely an ambition.“ —James Hoecker, energy attorney and former FERC Chairman

“…a thoughtful vision of the opportunities for the electric power industry to make use of new organizational and regulatory frameworks and new technologies so that it can successfully adapt to climate change, energy security, and economic efficiency challenges....”

—Paul Joskow, President of the Alfred P. Sloan Foundation

“…a treasure trove for anyone with even a smidgen of interest in the U.S. electric power industry and great for those, like me, working to reinvent the utilities.”

—Robert Farmer, President Concept Communiqués, Inc.

“Smart Power is fantastic! It is impressive how Peter Fox-Penner weaves together the moving pieces relating to electrical power transmission while identifying and explaining the associated policy and regulatory challenges.”

—Kelly de la Torre, Rocky Mountain Energy Blog

“For energy industry professionals, industry-watchers, policymakers, environmentalists, and students in these fields, this clear, well-researched presentation should be required reading.”

—SciTech Book News Review

“The trick is getting there from here—a challenge that Fox-Penner compares to ‘rebuilding our entire airplane fleet, along with our runways and air traffic control systems, while the planes are all up in the air filled with passengers’…. Smart Power makes it clear how hard that transition will be, but also how it could pay off.”

—Jennifer Weeks, SEJ Journal

“... Smart Power leaves us feeling better organized and educated on a very complex topic that the industry has likely only begun grappling with. It is a timely volume since it gives consumers, analysts, and policymakers important stepping stools for getting on the train that is leaving the station. That Fox-Penner takes on the job of lending structure and clarity to perhaps the most daunting challenge ever to face the electricity industry speaks volumes. But it is his sense of optimism and confidence in our success that makes the book a home run...”

—Diana Moss, Vice President, American Antitrust Institute

“An excellent treatment of the critical issues facing the electricity industry.”

—Thomas R. Kuhn, President of the Edison Electric Institute

Smart Power

Smart Power Climate Change, the Smart Grid, and the Future of Electric Utilities

Peter Fox-Penner

Washington | Covelo | London

Copyright © 2010 & 2014 Peter Fox-Penner All rights reserved under International and Pan-American Copyright Conventions. No part of this book may be reproduced in any form or by any means without permission in writing from the publisher: Island Press, 2000 M Street, NW, Suite 650, Washington, DC 20036 ISLAND PRESS is a trademark of The Center for Resource Economics.

Library of Congress Cataloging-in-Publication Data Fox-Penner, Peter S., 1955– Smart power : climate change, the smart grid, and the future of electric utilities / Peter Fox-Penner. p. cm.

Includes bibliographical references and index.

ISBN 978-1-59726-705-2 (cloth : alk. paper) — ISBN 978-1-59726-706-9 (pbk. : alk. paper) 1. Electric utilities—Deregulation—United States. 2. Electric power distribution— United States. 3. Power resources—United States. I. Title.

HD9685.U5F6144 2010 333.793′20973—dc22 2010002239 This new edition carries the ISBN 978-1-61091-589-2.

Printed on recycled, acid-free paper

Manufactured in the United States of America 10 9 8 7 6 5 4 3 2 1

Contents

Forewords xiii chapter one The First Electric Revolution

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chapter two Deregulation, Past and Prologue

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PART ONE  The Smart Grid and Electricity Sales 21 chapter three The New Paradigm

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chapter four Smart Electric Pricing

39

chapter five The Regulatory Mountain

51

chapter six The (Highly Uncertain) Future of Sales

67

xi

xii Contents

PART TWO  Supply Side Challenges 77 chapter seven The Aluminum Sky

79

chapter eight The Great Power Shift

95

chapter nine Billion Dollar Bets

123

PART THREE  Business Models for the New Utility Industry 137 chapter ten Energy Efficiency: The Buck Stops Where?

139

chapter eleven Two and a Half New Business Models

157

chapter twelve The Smart Integrator

175

chapter thirteen The Energy Services Utility

189

Conclusion

203

Afterword 213 Technical Appendix A 225 Technical Appendix B 239 Technical Appendix C 251 Notes 257 Bibliography 289 Abbreviations 321 Acknowledgments 325 About the Contributors 329 About the Author 331 Index 333

Smart Power

chapter one

The First Electric Revolution

I

N 1885, Muncie, Indiana, was a typical midwestern city. The rhythms of the city were set by the sun and the canter of horses pulling wagonloads in from

the surrounding farms. The largest factory belonged to the Ball brothers, makers of the much beloved canning jars. By night, the city’s only light came from smoky, flickering gas lamps. The countryside relied on candles and kerosene.

Over the next four decades, electricity transformed Muncie as it transformed the world. Shopkeepers found that smokeless electric lights were far better for attracting customers and less damaging to their goods. For the first time, mothers could allow their children to read alone at night, free of the fear of accidental but frequent lantern fires. The streets of Muncie were illuminated, and a system of twenty-five fire alarm boxes alerted the fire department much faster than a messenger could be sent by saddle.

Electricity, too, changed the Ball brothers’ factory. Before 1900 a team of two glass blowers and three preteen boys worked by hand to make 1,000 jars a day. The electric machines that replaced these workers took eight men to run and—in the same amount of time—produced 42,000 jars. Historian David Nye writes, “In Muncie’s foundries men seldom carried heavy loads, because 1

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an overhead crane with a powerful electromagnet could carry materials from one end of a plant to the other in less than two minutes. Three men operating it could do the work that previously required thirty-six strong day laborers.”1

Insull’s Industry As Muncie and thousands of other cities electrified, one man was smiling. It was not Thomas Edison, J. P. Morgan, or any of the many other electric inventors or financiers of the era. It was Samuel Insull, the son of an English lay preacher,2 who devised an industry structure and business model that enabled electricity to embark on an unbroken century of growth.

Insull rose from the personal staff of Thomas Edison to become CEO of one of the earliest utility holding companies, Commonwealth Edison.3 Along the way he mastered beyond all others the technology and economics of power demand and supply, the importance of utility regulation, and the value of different business and financial structures.

Insull’s visions of the industry rested on four pillars. First, it was cheaper to serve customers when their power use was aggregated via the largest possible web of interconnections—the system we now call the grid. Insull termed this the massing of consumption. The second pillar was economies of scale in production, or the industry’s natural monopoly attributes. Today some of these scale effects have faded, but they were immutable in Insull’s days and for decades thereafter.

When one’s costs go down as supply goes up, what is the logical sales strategy? Sell more and charge less. Insull and the industry’s finest marketing force sang “the gospel of consumption,” urging customers to buy ever more power and giving them discounts when they did. This was pillar number three.

Finally, Insull recognized that an industry with declining costs, high capital needs, and intensive political interaction would gain stability and protection from regulation. He wrote: For my own part, I cannot see how we can expect to obtain from the communities in which we operate, or from the state having control over those communities,

The First Electric Revolution

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certain privileges so far as a monopoly is concerned, and at the same time contend against regulation.4

In league with progressives like Robert M. La Follette, Sr., who favored government control over trusts and other critical industries, a system of independent state agencies was established to oversee utilities and their rates.

Insull pursued his vision ceaselessly, acquiring and combining small power systems around the United States. The rest of investor-owned systems followed suit. A scattered collection of small power plants owned by municipal governments and individuals became an industry of huge, centralized utilities, with roughly one-third remaining in its original ownership form. Insull’s vision of large supply, massed demand, increased consumption, and regulated rates reigned supreme. And without it, electrification might not have happened.

Insull, perhaps more than any other single person, changed American life.

Over the span of the next four decades, nearly every urban home and shop got electric power and lights. Housewives who had spent an entire day doing the wash could now start an electric machine that finished in an hour. Factories saw productivity gains as high as one hundred times pre-electric levels. With a radio at the hearth of nearly every American household, and theaters soon to have electric sound and later air conditioning, came the birth of mass communication and the modern entertainment industry.

Electric power became fundamental to our military strength. Well before World War II began, war planners called for a massive expansion of power production. During the war years the War Production Board closely directed the building of transmission lines and new federal hydroelectric facilities, especially in the Columbia and Tennessee river valleys. Among other customers, the Tennessee Valley Authority (TVA) supplied massive quantities of power to the secret Tennessee laboratory that built Little Boy and Fat Man, the atomic bombs dropped over Hiroshima and Nagasaki in 1945. By that same year, U.S. electricity usage had increased 60% above prewar levels, introducing additional economies of scale that had not been possible during the Great Depression.5 In the decades following the war, electrification permeated every facet of the American economy. The maximum rating of a turbine generator has grown

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by a factor of 1,000 since the power age of America began.6 The number of personal computers installed worldwide hit the one billion mark in June 2008.7 Patients in intensive care are wired to as many as a dozen electrical devices. Warfare is increasingly electronic. Video screens are everywhere—even in elevators, where the average viewer watches them for thirty seconds. The average American home used approximately 138 kilowatt-hours a month in 1950; today the number is closer to a thousand (1 kilowatt-hour is ten hours of a 100-watt fluorescent bulb or about half a load of laundry).8 In 2003 the National Academy of Engineering convened a jury to recognize the most important technological developments of the century. The Academy looked out across a country with nearly ten thousand power plants, six million miles of power lines, and an inconceivable array of electric devices.9 The Academy had little trouble choosing electrification as the preeminent engineering achievement of the twentieth century.10 But all things must pass, and after a century of dominance, the sun is setting on Insull’s creation.

The Second Electric Revolution Today the electric power industry faces challenges far larger than any in its history. These challenges are motivated by two worldwide policy imperatives. The first imperative is the need to adopt policies reducing the impacts of global climate change. Scientists and policymakers now largely agree that greenhouse gases (GHGs) are growing at a rate that will soon yield dangerously high concentrations in our atmosphere. To reduce the likelihood of severe damage from storms, droughts, disease, and ecosystem shifts, GHG concentrations in the atmosphere must be limited to less than 450 parts per million.11 The second policy imperative is the need for greater energy security. Imbalances between the supply and demand for oil, natural gas, and other fuels and key commodities can pose a threat to the economic stability and security of import-reliant countries such as the United States. Oil imports provide more than half of U.S. oil consumption and continue to grow. The U.S. trade deficit,

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which currently exceeds $1 trillion, is directly related to the cost of importing oil, which contributes an estimated $700 billion a year.12 As world demand increases, suppliers such as Saudi Arabia, Iran, and Russia will continue to gain even more geopolitical leverage at an alarming rate: in 1980, the United States bought 25% of its oil from the Organization of Petroleum Exporting Countries (OPEC); by 2030 the figure will be 47%.

For countries dependent on imported oil, electric transportation constitutes an important new pathway toward greater energy security. Because U.S. electricity is made from many types of fuel, most of them from domestic sources, every auto propelled by electric power reduces the demand for imported oil. The development of lower-carbon transportation options could provide as much as $120 billion in consumer benefits by 2030.13 With electric transport products about to take off, the power industry must prepare for a role it has never played before: bolstering our energy security by supplying power to an electrified transport fleet.

Climate change in particular poses an extraordinary challenge for the business of delivering electricity. Most policies under discussion call for U.S. greenhouse gas reductions of 80% by 2050—well within the lifespan of many power plants operating today. The latest science suggests even steeper cuts may be necessary.14 To achieve this objective, the industry will have to make massive changes in its fuel sources and generating plants at a wholly unprecedented pace. A system of nearly one million megawatts, operating mainly on fossil fuels, will require a trillion-dollar retooling in the span of the next several decades.15 In this massive reconstruction, the challenge is not simply one of swapping out old plants for new ones. Every change must be checked for its impact on reliability and integrated into the continuous reliability management of the entire region. In some cases, new transmission capacity will be needed, introducing a number of new questions and challenges.

The size and cost of the carbon reductions needed for a sound climate policy make greater energy efficiency an essential part of a sound climate policy.

Energy efficiency is universally viewed as the best and cheapest means of reducing carbon emissions. But the power industry was designed to make and sell

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as much power as possible as cheaply as possible. Repurposing the industry to both sell and save electricity raises extremely difficult financial, regulatory, and managerial questions.

As the industry shifts its supply sources, builds transmission, and increases its energy efficiency efforts, the technologies at the core of its operations will shift dramatically. Over the next thirty years, the industry will adopt the socalled Smart Grid, and the architecture of the system will shift from one based exclusively on large sources and central control to one with many more smaller sources and decentralized intelligence. The Smart Grid will mark a total transformation of the industry’s operating model—the first major architectural change since alternating current became the dominant system after the Chicago World’s Fair in 1893.16 As the industry adjusts to these technology and paradigm shifts, its viability requires that we change its financial and regulatory footings. Technology, economics, and environmental considerations have rendered the foundations of Insull’s business model obsolete. Thanks to the Smart Grid, the massing of consumption will give way to individual control. The industry’s scale effects have changed dramatically, though not entirely. Far from the gospel of consumption, we now sing the praises of greater energy productivity and sustainability.

Regulation, Insull’s fourth pillar, remains in a form that no longer serves our ­objectives.

The new electric power industry will have to be designed with three objectives in mind—creating a decentralized control paradigm, retooling the system for low-carbon supplies, and finding a business model that promotes much more efficiency. These imperatives together will define the future of power. A system and a business model that each took more than a century to evolve must be extensively retooled in the span of a few decades. Many of the technologies and institutions needed for the job are still being designed or tested. It is like rebuilding our entire airplane fleet, along with our runways and air traffic control system, while the planes are all up in the air filled with passengers.

This book explores the future of the power sector in three parts. Part 1 begins by looking at how the industry interacts with its customers, including the overall level of sales and how the shift in the industry’s operations enabled by

The First Electric Revolution

7

the so-called Smart Grid could revolutionize it. These new grid technologies will transform electric pricing and create enormous regulatory challenges, all with little or no growth in overall power sales. We examine these issues in the next five chapters.

In the second part of the book, Chapters 7 to 9, we turn to the supply side of the industry and the need to decarbonize our power sources. We’ll consider the costs of, and tradeoffs between, large-scale power sources such as coal plants and small-scale power sources close to customers. As one might imagine, the transmission system plays a pivotal role in this discussion.

Part 3 turns to the question of how utilities can structure themselves to respond to all of these challenges and remain viable investor-owned firms. This is an especially difficult question, as the industry must finance hundreds of billions of dollars of investment and retool its operating paradigm without much of an increase in power sales for many years to come. The book concludes by showing how both the industry’s current business model and its regulatory structure must undergo a radical redesign to pursue a new economic mission: to sell least-cost energy services, not larger amounts of kilowatt-hours.

While we might hope that an industry this important will always find a way to keep the lights on, the same could be said of a global financial sector that collapsed in mid-2008 with astonishing speed and momentous repercussions.

Even within the power industry, a much smaller set of challenges ignited the California electricity crisis of 2000, bringing on rolling blackouts, bankruptcies, and billions of dollars in increased electricity costs. Getting it as right as we can is important—for our climate, our economy, and our safety and national security.

chapter two

Deregulation, Past and Prologue

I

N 1990, the future of the power industry could be summarized in a single word: deregulation. The majority of policymakers and academic experts

largely agreed that the power generators should follow in the footsteps of airlines, telephone companies, natural gas suppliers, and trucking firms and use markets rather than regulators to set prices. A new breed of energy companies, led most visibly by Enron, had made a very profitable transition from regulated to deregulated natural gas companies. They were intent on replicating their success in the much larger electric industry.1 Twenty years later the issues that absorb the industry—and that are the main subjects of this book—are climate change, energy efficiency, and the impacts of the Smart Grid. Whatever happened to deregulation? And what does this say about the future, when the industry grapples with enormous, unpredictable change?

As we are about to see, deregulation was oversold by its proponents and implemented abysmally by federal and state policymakers. Poor execution led to a crisis of epic proportion in California and a dismal track record in many other parts of the United States. While many of the problems with power markets 9

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have been fixed with much stronger oversight and better market designs, power markets still face thorny problems and a fair number of unhappy customers.

Of the twenty-three states that deregulated retail rates, at least eight have either suspended or scaled it back. Most of the remainder are reinstituting some form of governmental planning or oversight process. In a nationwide survey conducted in 2007, a majority of state regulators could not identify a successfully deregulated state, and about a third admitted they had serious plans to reregulate their own. Even in England, where retail power deregulation has been most successful, the government is cautiously moving back toward greater utility oversight.

Most importantly, however, the nature and urgency of the problems facing the industry are not seen as problems that can be solved by less control over electric rates. Had the legacy of deregulation been different, policymakers might look to even greater scope for market forces. As we shall see, competition will unquestionably play a big role in the future power industry—but it will be in a form very different from Enron’s vision of an electron market free-for-all.

The Industry’s Tangled Structure The economic and regulatory structure of the American power industry is a contraption only a lawyer could love. From the engineering standpoint, there are three vertical stages of production—generation, transmission, and distribution. Generators make the power in power plants, high-voltage lines transmit the power to substations in your neighborhood, and the small wires and equipment on the poles leading to your home or office are the distribution system.

Electrons are created in the generator and flow through the grid into your appliances and lights. When a single company owns the entire system—from the generator to your meter—and sells you the power made in its generators, it is said to be vertically integrated.

The entire industry is not integrated, which gives rise to a framework in which different parts of the system are governed by different laws. Wholesale (or “bulk”) power refers to power traded between a generator and a distributor

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or between two utilities, much like other wholesale markets. Under the Federal Power Act, a federal agency called the Federal Energy Regulatory Commission (FERC) has sole jurisdiction over pricing (rates) in the wholesale portion of the industry. This includes all high-voltage transmission (over large distances), but not lower-voltage local distribution systems. The FERC operates like a regulatory agency, with commissioners appointed by the president and confirmed by the U.S. Senate. And although the FERC can set the rates for sending power across any high-voltage line, it has almost no authority to order any kind of utility to build a line where one is needed. This authority resides with each state.

All transactions over the distribution system are regulated by state public service commissions (PSCs) under state laws, including the final retail sale of the power to each customer. Each state’s laws set out the authority of its state PSC. In every state except Nebraska (which has only public power), the laws require that the PSC set regulated, cost-based rates for transporting power over the distribution system. Note, however, that transporting the power is legally distinct from selling it. Where there is traditional rate regulation, the PSC is also required to set cost-based rates for the sale of power to each customer class (e.g., residential, small commercial, large commercial, etc.), and the rates for transport and sale are bundled into a single rate.

To make matters more complicated, there are also generators owned by federal, state, or local government agencies. These are subject to much less wholesale and transmission regulation because they are believed to be unlikely to charge unfair rates and get away with it. In most states there are also distribution systems owned by government agencies and nonprofit, customer-owned cooperatives (co-ops) that distribute and sell bundled retail power. These government and co-op power sellers are seldom subject to state regulation because they, too, are viewed as unlikely to charge unfair prices.

This complex industry and regulatory structure is summarized in Figure 2-1. You can think of it as a wholesale market of power plants and the grid regulated by the FERC and retail distribution systems and integrated utilities rateregulated or deregulated by the states. Alongside them all are publicly owned electric systems of all types that are usually not regulated by state or federal

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Figure 2-1. A Simple Electric System.

agencies but generally act similarly, setting rates equal to average costs that are similar to those of the IOUs but for the latter’s inclusion of shareholder equity returns.

Enter Deregulation Electric power deregulation is often thought of as a process with two giant steps, at least in theory. First, take all the power generators in the country that are now regulated and change the rules so they charge whatever prices they want. In other words, sale of the commodity electricity (kilowatt-hours), formerly purchased only from your local utility, can now be purchased from any nonderegulated generator at whatever price the market has set. However, this power can only be delivered to you via the transmission grid and the lower-voltage local distribution system. Both of these remain fully regulated. Thus, even though the market sets the wholesale prices for power itself, the rates for delivering it over the transmission and distribution wires are set by federal and state regulators, respectively. The overall price customers see on their bill is the sum of the

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market generation price and the two regulated delivery charges, the latter often accounting for more than half the total bill.

The second step in idealized deregulation is to make sure competition works well. Here, as in most other markets, power consumers should be able to count on antitrust officials and utility regulators to monitor and fix problems like price gouging in the new markets for generation if and when they occur.

That was the theory, at least. But due to the complex structure of the industry, and the absence of a sufficient national political consensus, restructuring did not proceed this way. Congress did not enact—nor did any president propose—a bill to deregulate generation and force all states to allow retail choice.

Instead, deregulation occurred incrementally at the federal (wholesale) level and state by state at retail.

Not that people didn’t try. The movement to deregulate power began with papers emanating from think tanks in the 1970s, fueled by dissatisfaction with high power rates and the cost overruns at nuclear power plants in that era.

Led by Enron, a broad coalition trumpeted the benefits of electric deregulation. Retail choice was to be the unshackling of “the last great monopoly in the U.S.,”2 a move that would lower electric rates dramatically and allow electric customers to choose the supplier of their choice. Kenneth Lay, Enron’s late champion and chairman, said electric choice would be equivalent to “the largest tax cut in history.”3 Industry-backed “consumer groups” published projections of savings from deregulation as high as 43%.4 The U.S. Department of Energy, falling in line with the prevailing winds, found that retail competition would lower rates for consumers in every state.5 Other claimed benefits of deregulation included job creation, improvements in the reliability of service, and a cleaner ­environment.

Around 1994, the pro-deregulation forces began to get some traction. Although they could not convince Congress to pass a bill deregulating either the wholesale or the retail markets nationwide, they did convince the regulators at the FERC that they already had the authority to take two key deregulatory steps.

First, they could create a system of “open access” in which any power generator could use anyone else’s transmission system on a first-come, first-served basis

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to deliver power from a generator to a state-regulated distribution system. Second, the FERC started allowing some generators to make wholesale sales—sales only to other utilities, not actual end users—at deregulated rates. Once federal regulators enacted these key preconditions, advocates of deregulation could approach individual states. State legislatures could then vote to allow competition among deregulated retailers of power, or “retail choice,” as it became known.

About half the states did just this, almost all in regions where retail rates were well above the national average.

The Partial Fix Why was deregulation introduced in this piecemeal fashion rather than as a swift, one-shot measure? Some of the reasons are purely political. Many utilities in states where electric rates were comparatively low, which included much of the South, Midwest, and West, thought regulation was working just fine in their area. If it wasn’t broke, they argued, don’t fix it. The argument that competition would force the cost of power down could not outweigh satisfaction with the status quo and the raw lobbying power of the IOUs in their legislatures.

The remaining reasons for easing into partial restructuring had to do with the difficulty of making sure deregulation would work. For competition to keep prices under control, there would have to be many competing generators in every area. Each of these generators has to be able to use the transmission and distribution systems to send its power on terms equal to its competitors. In other words, there are three essential preconditions to sound competition: a sufficient number of competing power generators (“deconcentration”), a transmission grid large enough to physically accommodate all competitors, and “open access” rules so that power can be shipped from generators to customers.

Another important feature of successful markets is the ability of buyers to react to price increases, that is, to use less when prices go up and more when they go down. But most of us don’t even know that power prices vary hour by hour, much less how to find out what they are and then react to them. Our efforts to save power are based on our perception of annual savings, not on the ability to adjust power within a day or a week.

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Unfortunately, there were very few parts of the country in which any of these conditions, let alone all, were achievable on the timetables deregulators wanted. Establishing any one of these three preconditions would be a significant political, regulatory, and financial challenge (as we shall soon see, the Smart Grid does take care of one of the three). For the most part, state and federal policymakers did not want to do the political heavy lifting required to create these conditions.

To give state policymakers the assurance that deregulation was going to work, proponents agreed to put features into state bills that were intended to protect against worst-case scenarios. These included the sorts of features one might expect: a requirement that deregulated sellers register with the state and prove their creditworthiness, periodic reports on the health of the new power markets, and so on.

The most important protection, however, was to allow any electric customers to stay with their current rate-regulated service if they did not want to switch. This option to retain regulated rates was unprecedented. It was as if airlines were to offer passengers the option of buying any ticket they chose or buying a special ticket whose rates were still set by the Civil Aeronautics Board.

It was continued regulation right alongside deregulation, with customers free to choose back and forth between them. But electricity is uniquely important, and some regulators recalled that, when local phone service was deregulated, customers were furious when they were told by government that they had to choose a deregulated provider.

The regulated prices offered in deregulated markets became known as “provider of last resort,” or POLR (pronounced “polar”), rates. One crucial decision remained: What rate should be set for POLR service? State policymakers had been told repeatedly by deregulation’s cheerleaders that it was going to create much cheaper electricity in their states—10% at the very least, and maybe a lot more.

Although the opponents of deregulation were highly skeptical that prices would drop, they knew the proponents would argue strongly that they would.

If so, there could be no harm in creating POLR rates 10% lower than current prices and frozen for five or ten years. Who would want to stay on this POLR

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rate if market prices were even lower? And if no one stayed on the regulated POLR prices, regulated sales would wither away, achieving the ends deregulators wanted.

The bluff worked. Governors and legislators adored this solution, as it allowed them to deliver tangible rate savings to every electric ratepayer immediately upon the enactment of deregulation. Of course, these legislated rate reductions and freezes applied only to customers who stayed with their traditional regulated utility. But this was seen as just the beginning of a new era of much lower prices for everyone.

Following deregulation, the reality was that it quickly became quite difficult for deregulated sellers to compete with the low, legislated POLR rates in many states. When the price of fuels used to make power went up, deregulated sellers had to raise their prices to cover their costs. Regulated POLR providers were either barred from raising their prices or had to wait to get permission, keeping lower prices much longer than their deregulated rivals. When this occurred, customers understandably chose to stay with the regulated POLR rates.

As this scenario played out, deregulated sellers found they could hardly ever offer small customers a price cheaper than the POLR provider, and almost no small customers switched. In many other states, however, only a few percent of residential customers switched to competitive suppliers, while roughly equal numbers switched back to regulated service. They could sometimes offer better rates to larger customers, and large customers often did migrate to competitive providers And then came California.

The Western Energy Crisis May 2000 began as a fairly ordinary month in California, but it did not end that way. On May 22, power prices suddenly spiked for no apparent reason. For the first time ever, prices hit a “safety valve� price cap of 75 cents/kWh—over twenty times the normal prices. Prices exceeded 25 cents (eight times the prior average) for eighty-five hours between June and September, and hit the cap another thirty-four hours in that period. Prices in all other hours continued to rise

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as well and with them the costs of energy purchases by power buyers throughout the western United States.

And this was only the beginning. Although prices calmed briefly in September, a November cold snap brought prices back to record levels. Supplies were even lower than in the summer, and natural gas prices peaked at approximately fifteen times their maximum level the year before. Through the first quarter of 2001, wholesale deregulated prices in the northwestern United States remained near 50 cents/kWh, the highest ever seen in this typically low-priced region.

Meanwhile, California repeatedly faced shortages of supply, threatening the reliability of the system and prompting the grid operator to declare supply emergencies on fifty-five days in 2000, and the first intentional blackouts since World War II. On December 14, 2000, the U.S. Department of Energy took the extraordinary step of issuing an emergency order requiring all generators and power marketers to sell their available surplus power to the California markets. Despite the order, supplies offered to California continued to dwindle, and during January and February 2001, the California grid operator was forced to implement its most extreme emergency procedures for thirty-two consecutive days. The system was in danger of imminent collapse and consumers experienced rolling blackouts.6 As you can imagine, California’s governor and other state leaders were desperate to reduce power prices. Because the power markets were wholesale, and therefore under the exclusive jurisdiction of the federal government, the state could not itself impose price caps on the generators. Instead, it desperately sought to build more of its own power generators, signed contracts with new suppliers at fixed prices, and imposed some of the most successful short-term conservation efforts in history. The FERC tried a series of measures to lower prices, ultimately including caps on power prices in the entire western United States. By June 2001, these actions succeeded in taming the market, and prices fell almost as suddenly as they rose. On July 1, 2001, prices were back to about 6 cents/kWh and the crisis was over for good.

The crisis left a trail of economic devastation in California and beyond. Between June 2000 and 2001, Californians spent an estimated $33 billion more than they had paid during the prior twelve months, in addition to suffering

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through rolling blackouts and brownouts and the financial collapse of their utilities.7 Power buyers in the rest of the West also paid much more for power, leading to rate increases of at least $9 billion outside of California. Largely due to the crisis, California’s governor, Gray Davis, was ousted in a recall election in November 2003. But perhaps the greatest damage of all was to the idea that deregulating retail electric sales was a good idea. No elected officials wanted to take a chance that anything remotely resembling the crisis would ever occur in their state. West Virginia senator Walt Helmik summarized the views of many legislators in 2001 when he said, “Last year I thought it was a slam dunk that we were going to do this. But since then other concerns have come up, especially the situation in California.”8 Momentum toward retail deregulation froze.

The final blows came between 2006 and 2008, when the 10% POLR rate reductions enacted at the start of retail choice started expiring. In the decade since the POLR rate discounts were enacted, power plant fuel costs had risen an average of 110% and general inflation had increased prices 25%.9 When regulators readjusted regulated POLR prices to match current average supply costs, they found that increases of 70% or more were necessary.10 Although regulated rates (including POLR) increased by a similar amount, any illusions that deregulation was going to create enormous and visible savings were dashed for good.11

Deregulation’s Legacy The unhappy history of deregulation in the power industry creates an understandable air of caution among most industry policymakers. Proposals to change the structure of the industry are now met with much greater skepticism than they were in 1990. The proponents of change need to convince policymakers that consumers will be substantially better off and that nothing will go wrong—no blackouts, no messy bankruptcies, and no lessening of the quality of service.

The industry’s skepticism toward deregulation is part of a larger reassessment of the idea occurring in the economics profession and policy circles. Even before the financial markets collapsed in 2008, the reappraisal was suggesting that the use of competition to achieve public ends was here to stay—but that

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markets are prone to very severe problems if they are not adequately designed and policed.12 While government agencies need not set prices, they cannot sit back and assume that competition will deliver broad benefits without the careful structuring and oversight, including effective systems to protect against fraud, excessive risk taking, market power, and other problems.

Meanwhile, the era of deregulation has left the power industry with an even messier structure than we had before deregulation began. About half the country is now served by state-regulated firms who own many generators, but also buy much of their supplies, including nearly all of their renewable power. The other half of the country is served by deregulated power retailers, owned mainly by large independent generators, delivering over fully regulated wires. Utilities owned by municipalities, power districts, and other public entities are mostly unregulated and also buy some supply from the wholesale markets. Customerowned cooperatives are similar and own many generators. Atop it all sits the wholesale power market (price decontrolled) and the high-voltage grid (price and access regulated), both overseen by the FERC. Even without deregulation’s baggage, this byzantine legal and economic structure makes sweeping organizational change in the industry quite difficult.

Every change must be weighed against its impact on many different industry segments, each with different ownership, goals, strengths, and constraints. In this regard, cross-cutting changes in the power industry face adjustment cost and jurisdictional barriers similar to those bedeviling the reform of the health care and financial services sectors.

The need to rapidly reduce the industry’s carbon footprint is also prompting a modest retreat toward regulation and integration. The pace at which the industry must make investments in low-carbon generation, energy-saving technologies, and new grid capacity carries with it tremendous investment risks.

Regulation is designed to ensure that utilities do not earn excess profits, but also that they earn enough to keep their businesses working well. In this situation, regulation provides a modicum of insurance against some risks, such as technology failures or sudden policy shifts.13 With climate policies forcing big changes and large, risky investments, more CEOs are thinking it worthwhile to give up the prospects of earning higher, unregulated profits in exchange for

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a ­little more protection against downside risks that aren’t well understood and potentially huge.

Like every other disruptive technology, however, the changes brought on by the Smart Grid do not respect traditional jurisdictional and financial boundaries. As we shall see in the next chapter, the Smart Grid will change the entire industry’s operating paradigm and open up entirely new customer relationships. Later we’ll see that the need for greater energy efficiency also raises tough questions about industry structure, incentives, and responsibilities.

The future will be filled with a tension between the forces for change propelled by the Smart Grid and energy efficiency policies on one side and the perception that keeping the current structure may be more reassuring to investors, CEOs, and policymakers on the other. Deregulating more of the industry will be a challenging proposition, caught between technological change that regulators will be severely challenged to keep up with and memories of deregulatory problems they desperately want to avoid. As we will see in Part 3, the solution will be business models and reformed regulation that plug deregulated competitors into the right parts of the Smart Grid but preserve regulation and oversight in the parts of the system that still need it.

smart power anniversary edition: Climate Change, the Smart Grid, and the Future of Electric Utilities

By Peter Fox-Penner Available from Island Press | Amazon | Barnes & Noble Your Local Independent Bookstore “Few economist/engineers understand the electricity system as well as Peter Fox-Penner, and far fewer can explain it as lucidly. Whether or not you agree with every detail, his vision of the opportunities, risks, uncertainties, and tipping-points of this vast and crucial industry is powerful and provocative.”

—Amory B. Lovins, Chairman and Chief Scientist, Rocky Mountain Institute

Readers on the first edition: “Best book I’ve seen on smart grid and utilities” —Amazon reader “Author Peter Fox-Penner’s Smart Power provides much needed context for discussion on meeting the nation and the world’s energy needs.”

—Amazon reader “An excellent analysis of alternative futures in power by an economist, taking account of the complex regulatory and industry environments.”

—Amazon reader

Paperback | $28.00 9781610915892

Peter Fox-Penner, Ph.D., is a consulting executive and an internationally recognized authority on energy and electric power industry issues. He is a Principal and the Chairman Emeritus of The Brattle Group, a leading international economic consulting firm.